Facing 3 risks: Liquidity, Credit, Equity

Mohamed El-Erian is chief economic adviser at Allianz, the parent of Pimco, where he formerly served as chief executive and co-chief investment officer.

In a recent interaction, he mentioned that investors should not expect a quick recovery once the bottom is reached.

We are going into a global recession. The economic damage is going to last. We’re going to come back. We’re going to turn around, but it’s going to be a difficult journey.

Below are some extracts from his conversation with Jeff Ptak, Morningstar’s global director of manager research, on the market perspective.

The instability in the capital market.

People are unable to do what they want to do. And when you're not able to do what you want to do, in the financial markets, you're often forced to do something.

Let me give you an example. I take money out of a high-yield bond mutual fund because I need cash. The act of me taking out money forces my fund manager to raise cash. In order to raise cash, the fund manager will have to sell something. Now, that fund manager typically knows what they want to sell. However, when markets are under stress, you're not able sometimes to sell what you want to sell. So, you end up selling whatever you can sell. Because the last thing you want to do as a fund manager, is to tell your investor that he can't get his cash back. Because once you do that, the damage to your business is very big. So, the fund manager will end up selling whatever they can sell.

That results in a number of unintended consequences.

First, it takes the pressure that was supposed to be in one segment to something else, selling pressure contaminates something else, that's called contagion.

Second, it results in the fund manager having a portfolio that is actually now different from what they really want. So, they didn't have to think of how am I going to adjust to the fact that I have been forced into a situation which I don't like.

Third, it puts enormous pressure on the value of the fund, which means that others are going to start looking and worrying. And next thing you know, you're cascading the self-feeding mechanisms.

So, the reason why people worry about the functioning of markets as opposed to the level of asset prices is that they are worried about all the self-feeding dynamics that can spread disruption.

Why did we get there?

We've come from a period where investors were living the dream, as I call it. Look at 2019. Despite sluggish economic and corporate fundamentals, the S&P was up 30%. More risky assets were up even more. At the very same time that that happened, you also made money on U.S. government bonds. So, you made money on the risky stuff and you made money on the risk-free stuff. That is not supposed to happen. And at the same time, volatility was very, very low.

What that tells you is that the marketplace has been conditioned to care about only one thing to the exclusion of everything else. And that is central bank liquidity, particularly the predictable and ample injection of central bank liquidity.

The result of that is the market underappreciated liquidity risk, credit risk and equity risk. And we're now unfortunately all three.

The impact on developing economies.

I think the first implication will be even more tragic human tolls. Because you deal with a lot of countries whose health infrastructure is really weak. If it spreads there, the human suffering is going to be absolutely enormous, because the healthcare system will be overwhelmed very early on.

In terms of economic and financial consequences, it will reinforce the breakdown of global trade and supply chains.

It will also make people revisit the investment theme of developing countries always growing faster. So, you should always allocate to developing countries.

I've been warning for three years now that we have to be careful that as we enter a more fragile landscape economically and financially, we have to remember that emerging markets don't have the resilience of markets.

So, every year for the last three years people – one of the major investment recommendation was to fade the U.S. equities because they have done so well, they've outperformed the rest of the world by so much, which they have and move into international markets and move into emerging markets. And I said over and over again, there's a reason why you should not do this now. It's about resilience. The time will come when you should fade U.S. equities in favour of international exposures. But we're not there yet.

I think that what's going to happen now is people are going to realise that investing in less developed areas comes with a host of risks that one of which is less structural resilience.